The Main Reasons For The Creation Of Basel

Published Date: 02 Nov 2017

Hu Yu

Contents

Executive summary

This report is suitable to RBS for investor consultancy of UK market.

This report is based on Basel III.

This report is about the Basel III.

The references are from: website.

The main issues are: time limited, Basel III is new and just started hard to find relevant data.

The report is made by RBS.

1. The main drivers for the creation of Basel III

In 2007, the Subprime lending Crisis was happened in the USA, and finally became a worldwide Financial Crisis, the influence continued till now. A lot of bank broke during this time, large banks like Lehman Brother could not escape, the benefit of the depositors was been hurt strongly. During this crisis a lot of issues in Basel ii had been found:

The overall quality of Capital of global banks’ is poor while the Financial Crisis was happening.

There was not a consistent regulation for the leverage for the recent regulation system.

Sufficient attention has not been paid for Procyclicality in the financial system.

Strengthen risk management for individual financial institutions, and lack of systemic risk considerations.

In order to strengthen risk management and regulation for bank industry, the Basel association present the Basel iii, the Basel iii is aim to enhance the ability of defence financial shock and economic fluctuation, enhance risk management and management level, and enhance the diaphaneity and Levels of disclosure.

The main reasons for the creation of Basel iii are:

Avoid the moral hazard of ‘too large to fail’.

To reduce the social cost of the failure of a financial institution, as a result that may not cause a wider damage.

To protect the financial system stability.

To protect the real economic.

Those reasons drove the Basel Committee to change the unsuccessful Basel Accord, to make the market going better and safer.

2. Differences between Basel II and III

Basel iii reflects the newest idea of global banking industry regulation.

Basel II is based on the Asia financial Crisis in 1997, it is aim:

To amend the old Basel Accord( Basel I).

To standardize the risk management system.

To improve the risk management ability of International financial Services.

The core idea for Basel II is three pillars:

Minimum Capital Requirement: the minimum capital adequacy ratio no less than 8%, the core capital adequacy ratio of the bank’s should be no less than 4%. That could make the bank more sensitive for risk, and more effective for operation.

Supervision and inspection from Regulatory departments: the regulator can decide if the bank could be operated successfully by monitor, and can give some improvement project.

Market Discipline: Bank should announce their capital structure, Risk Exposure, the internal evaluation mechanism of assets to charge and the strategy of risk management for the bank.

Basel III is based on the Subprime Crisis in 2007 while the Basel II was just announced. After the experience of the crisis, Basel III focuses on safety more than efficient, it represents the new idea of Financial Services:

Micro supervision and Marco prudential combined.

Capital regulation and liquidity regulation both emphasized.

Pay attention to both number and quality.

Set up a new standard for bank supervision.

Due to the Crisis in 2007, the world economic is now walking in a swamp, slow and hard, lots of countries still can not move or even sink now, the crisis made managers know that there are a lot of fault in Basel II:

Systematic risk in Asset securitization trade.

VAR could not fully show the risk of trade.

Capital requirements and risk management of counterparty’s credit.

Off-balance sheet risks reflect is insufficient.

Transparency of complex-structure products trading.

The main change of Basel III:

Capital:

No less of 7 per cent of banks’ Risk Weighted Assets which was 2% in Basel II must be used as a buffer to against losses.

The liabilities of core tier one will be narrowed by definition.

Leverage rate will be introduced to the global financial regulation system.

Risk Weighted Assets:

Improve both quality and quantity of capital, updates the calculation tools for the counterparty credit risk.

The financial institution asset value correlation (FI AVC) will be amended to increase the Risk Weighted Assets for banks’ exposures to large and/ or unregulated financial institutions.

Liquidity:

The Liquidity Coverage Ratio (LCR) defines the amount of unencumbered, low risk assets (such as cash or gilts) that banks must hold to offset forecast cash outflows during a 30-day crisis.

Outflows are estimated, based on the nature of the customer relationship and the type of product Leverage.

A new leverage ratio of 3 per cent is due to become mandatory in 2018. This seeks to ensure banks apply adequate capital to all their exposures, including those off balance sheets, and without applying any risk weightings.

3. Implications of implementing Basel III liquidity requirements

Standard & Poor's Corp stated: Basel III will increase the cost of bank loan, and the cost will be surely passed to the enterprises.

Basel III set up a much higher rate of buffer against losses; the banks’ Risk Weighted Assets have increased at least 5% from Basel II to Basel III. Presume the international capital flow as a fixed number, before Basel III 98% of the capital could be used, but for Basel III only (98%-7%+2%-2.5%) =90.5% could be used for loan.

As the same number of capital size, the available capital has decreased at least 7.5%, while the number is larger the Risk Weighted Asset is larger, because of the characteristics of bank industry, the asset-liability ratio are higher than any other industries, actually 92% was said as a safe rate of ratio for bank, which means 92% of banks’ asset is from loan, in another word, 92% of banks’ assets are from depositor.

Money from depositor are not free, the increasing 7.5% of total asset for the bank could not get any income for the bank, and the total unavailable asset is 9.5% nearly 10% of the total asset of bank could not been used to gain profits. To presume the average Account interest is 1%, the whole asset of the bank is £ 100:

Bank asset: £ 100 available asset for loan：£ 90.5， interest：1% * 92% * 100 = £ 0.92， presume the available asset has all been borrowed: the lowest interest should be £ 0.92/ £ 90.5, compare with Basel II: the available asset is £ 98: £ 0.92/ £ 98. The cost is higher than Basel II.

Liquidity requirements: (Ernst & Young, 2013)

The LCR, which is designed to establish a minimum level of high-quality liquid resources sufficient to meet an acute stress lasting for 30 calendar days.

The NSFR, which is designed to influence the structure of funding by creating incentives for banks to fund assets that are not readily saleable with stable funding.

4. Use of literature and evidence of wider reading

Ba S S (2012), The influence of Basel III in Chinese banking industry. http://www.cnki.net/

Deloitte (2012), Unscramble of Basel III, http://www.deloitte.com

RBS (2013), Basel III: Need to know, www.rbs.co.uk/

Ernst & Young, (2013), Basel III liquidity requirements and implications Implementing the framework, http://www.ey.com/

JP Morgan (2013), Liquidity Regulation in the UK & Europe Impact on International Banks and Broker-Dealers www.jpmorgan.com

ICBC, (2013), The Impaction of Basel III for Europe is stronger than USA, WWW.ICBC.COM

China Banking Regulatory Commission (2013), Basel III: Content and Influence, www.cbrc.gov.cn/

Goldman Sachs (2013) Basel III Impact Report, http://www.goldmansachs.com